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Crowdfunding
in one form or another has been around for years but has become a
sexy buzzword of late. The majority of news articles about it are
positive, to the point where many seem to view crowdfunding as a
cure-all for small-business funding woes. But this hype has
clouded a number of pitfalls both entrepreneurial hopefuls and
prospective investors need to be made aware of before jumping on
board.

Crowdfunding has little application to business unless an
entrepreneur only needs a small amount of money to get started.
For projects requiring $5,000 or less, for example, it may be the
right route. But for anything larger -- especially where the
total investment is in the tens of thousands or greater – it
usually won't suffice. Small amounts of capital can certainly
help start a business initially but most will need to be
recapitalized. Unfortunately, subsequent capital is not as easy
to secure as some would assert.

That means that many of these “crowdfunded” businesses are often
severely undercapitalized and that could translate to
dramatically lower success rates. Some reports show crowdfunded
businesses fail at a higher rate than other small businesses. As
more crowdfunded businesses fail, fewer entrepreneurs will
trust its model and regulations may be
implemented. Companies requiring large amounts of
capital will likely continue to seek traditional funding or
forms of alternative funding.

Several pitfalls are often overlooked in the current crowdfunding
conversation. Here are a few.

Buyer beware: While the overall financial risk
can be less due to the “donation” or “contribution” being
smaller, crowdfunding investors are often far removed from the
business they are funding and therefore may not perform due
diligence in learning about the startup, the crowdfunding
platform, where their money is going or how it is being spent.

Entrepreneurs should choose their investors wisely, being
strategic and selective, ensuring they are receiving capital from
fully educated “angels” who understand the business, how their
money is being spent and what risks they are accepting.

Ongoing obligation: Many crowdfunding models
require the business to give something back to investors in the
form of products, services, ongoing discounts or deal with the
administrative and legal burden of having shareholders (new
regulation may complicate this further allowing non-accredited
investors to buy in). And while every investment should see a
return, businesses must be careful to not over extend what they
can deliver, or even negate the value of the funding to cover the
cost of fulfilling those obligations.

Entrepreneurs should be upfront about the relationship from the
beginning, outlining what discounts or deals are involved, if
any. Then investors can make the decision to participate or not.

Platform credibility: With about 450 platforms
now on the crowdfunding bandwagon, due diligence has never been more
important. Most do not disclose how many businesses
even get funding -- nor will they share how many of them
continue operating after the initial cash injection is
accepted. And as with any financial transaction, the rise in
options can lead to an increase in potential scams. There have
been some reports of instances where entrepreneurs have been
unable to withdraw the capital given to
them, making the donation worthless.

Both businesses and investors need to carefully investigate their
crowdfunding platform options to ensure it is credible and
legitimate. Some have better reputations than others, so make
sure to do your homework and choose the one that has a good track
record of results.

Finally, as a result of its growing popularity, politicians
jumped on new regulation for crowdfunding, namely the Jumpstart
Our Business Startups (JOBS) Act. The JOBS Act encourages
small-business funding by easing securities regulations. While I
applaud the intended value, it opens the door to more abuse
around soliciting investors. Many people don’t know, however, how
or when the many risks associated with crowdfunding will make
themselves known and even shape subsequent regulation.

So, is the hype around crowdfunding too good to be true? In a
word, yes. While for some it can be a viable option, businesses
and investors must start conducting the type of due diligence we
have come to expect in traditional financing models to make sure
it is right for them. There are inherent risks with
every new business venture, but for many, crowdfunding simply has
more risk than reward.